Page 51 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes Solution:
Forward Premium/Discount = (Forward rate – Spot rate)/Spot rate × 100
Days Forward Discount - Annualized (%)
30 – 11.64 %
90 – 12.51%
180 – 12.52%
360 – 12.54 %

3.3.4 Bid Price, Ask Price and Spread in Foreign Exchange Quotation

Interbank quotations are given as a Bid and ask (also Referred to as Offer) price. A Bid is the price
(i.e., the exchange rate) in one Currency at which a dealer will buy another Currency. An offer
or ask is the price at which a dealer will sell the other Currency. Dealers generally Bid (buy) at
one price and offer (sell) at a slightly higher price, making their profit from the spread, i.e., the
difference between the buying and selling prices.
Generally, the Bid-ask Spreads in exchanges between leading currencies are quite small. The
low spreads allow market participants to implement sophisticated risk management strategies
that require numerous forex transactions. Low spreads are also a boon for Speculators and they
have an important impact on trade and investment by making firms more willing to make or
receive payments denominated in foreign currencies.

In trading between freely convertible currencies, the size and frequency of transactions are
major factors affecting the costs and risks that underlie the Bid-ask Spreads. Transaction size
obviously has a great effect on transaction cost per unit of Currency traded while the frequency
of exchanges (the turnover rate) affects both transaction costs and risks. A high turnover rate
obviously reduces risks since there is less time for something unforeseen to occur. Moreover, a
high turnover rate spreads the fixed costs of Currency dealing over a larger volume of transactions
and permits a given volume of business to be effected with a smaller inventory of foreign
currencies, lowering the opportunity cost of committing funds to forex dealing.

The narrow spreads with which dealers must be satisfied when trading with leading currencies
may seem to imply that, in the absence of gains from favourable exchange rate movements, the
profits derived from Spot dealing are normally small. Narrow spreads can be very profitable,
however, if turnover rates are high and losses from unfavourable exchange rate movements are
few. If, for example, a dealer were to average a daily net gain of only 0.10 per cent of the capital
invested in Spot trading for a period of one year, this would provide an annual rate of return on
that capital of approximately 25 per cent.

While narrow spreads may suffice to provide attractive profits, some trading losses are inevitable.
Accepting an open position in a Currency, particularly overnight, is always risky but to avoid
such positions would unduly restrict bank operations and add substantial Hedging costs. To
reduce the risk of loss, dealers limit the positions their traders may take in different currencies
and adjust their quotations and spreads to prevent these limits from being exceeded more than
temporarily. By widening their spreads when exchange rates are unusually volatile, they reduce
the probability of losses, although at the cost of a possible loss of trading volume. Ever alert to
exchange rate trends, traders attempt to position themselves favourably within their trading
limits, comforting themselves in the knowledge that if they forecast exchange rates a little more
accurately than their competitors, that should suffice to guarantee themselves substantial
performance bonuses.

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